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Real Estate Finance > Lecture 7: Adjustable & floating rate mortgages > Flashcards

Lecture 7: Adjustable & floating rate mortgages Flashcards

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1
Q

Determinants of mortgage rates:

Price of money is ??.

A

Determinants of mortgage rates:

Price of money is interest rate.

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2
Q

Determinants of mortgage rates:

Interest rates are determined by demand & supply of mortgage funds.

A

Determinants of mortgage rates:

Interest rates are determined by demand & supply of mortgage funds.

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3
Q

Determinants of mortgage rates:

Demand for mortgage loans is ‘derived’ from demand for ??.

A

Determinants of mortgage rates:

Demand for mortgage loans is ‘derived’ from demand for real estate.

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4
Q

Determinants of mortgage rates:
? rate of interest is determined by:
1. what ? are willing to pay
2. what ? are willing to accept as compensation

A

Determinants of mortgage rates:
Market rate of interest is determined by:
1. what borrowers are willing to pay
2. what lenders are willing to accept as compensation

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5
Q

Determinants of mortgage rates:
Before providing mortgage funds, investors have to consider the opportunity cost, i.e. returns & risks of other investments.
Mortgage market is part of a larger ? market full of ? investment opportunities (e.g. stocks, bonds, …)

A

Determinants of mortgage rates:
Before providing mortgage funds, investors have to consider the opportunity cost, i.e. returns & risks of other investments.
Mortgage market is part of a larger capital market full of competing investment opportunities (e.g. stocks, bonds, …)

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6
Q

Determinants of mortgage rates:
Supply of funds allocated to mortgage lending is partly determined by ?.
? must be offered a ??? (?) high enough to give up ?consumption for future consumption/

A

Determinants of mortgage rates:
Supply of funds allocated to mortgage lending is partly determined by savers.
Savers must be offered a risk-adjusted return (interest) high enough to give up present consumption for future consumption/

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7
Q

Nominal interest rate:
r = ???
i = ? interest rate (interest earned on ? investments)
p = lender ? (compensation for ? & other risks)
f = expected ?

A

Nominal interest rate:
r = i + p + f
i = real interest rate (interest earned on alternative investments)
p = lender premium (compensation for default & other risks)
f = expected inflation

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8
Q

? mortgages: indexed to ? interest rate (typically 1-2% points above base rate).

  • In UK, Base rate (aka Official bank rate): set by ???? (MPC)
  • In US, ‘Federal Funds’ rate: set by ???? (FOMC) of t’ Federal Reserve Board.
  • Base rate is BOE official ? rate: the rate BOE charges to lend money ? to ? banks.
A

Tracker mortgages: indexed to Base interest rate (typically 1-2% points above base rate).

  • In UK, Base rate (aka Official bank rate): set by BoE Monetary Policy Committee (MPC)
  • In US, ‘Federal Funds’ rate: set by Federal Open Market Committee (FOMC) of t’ Federal Reserve Board.
  • Base rate is BOE official borrowing rate: the rate BOE charges to lend money overnight to commercial banks.
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9
Q

Most mortgage loans in the UK have an initial fixed (‘teaser’ or ‘honeymoon’) interest rate for a short period of time (usually up to 5 yrs) and then the rate is adjustable (variable).

A

Most mortgage loans in the UK have a fixed (‘teaser’ or ‘honeymoon’) interest rate for a short period of time (usually up to 5 yrs) and then the rate is adjustable (variable).

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10
Q

After the ‘honeymoon’ period, lenders start charging ‘???’ (SVR) (i.e. interest rate applied to standard home loans).

A

After the ‘honeymoon’ period, lenders start charging ‘Standard Variable Rate’ (SVR) (i.e. interest rate applied to standard home loans).

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11
Q

Lenders need to report t’ ???? (APRC) of their mortgages (total amount of interest that will be paid for the entire loan).
- Borrowers can compare the ? costs (i.e. APRC) of different mortgages offered by different banks.

A

Lenders need to report t’ Annual Percentage Rate of Charge (APRC) on all mortgage contracts they offer (total amount of interest that will be paid for the entire loan).
- Borrowers can compare the borrowing costs (i.e. APRC) of different mortgages offered by different banks.

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12
Q

Adjustable Rate Mortgages (ARM):
r = i + p + f
In an ARM, lender can adjust ? when ? changes.

A

Adjustable Rate Mortgages (ARM):
r = i + p + f
In an ARM, lender can adjust r when i changes.

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13
Q

ARM reduces but does not ? interest rate risk for lenders.
The longer the adjustment interval, the ? the interest rate risk.
But ARM still transfers some interest rate risks to ?.

A

ARM reduces but does not eliminate interest rate risk for lenders.
The longer the adjustment interval, the higher the interest rate risk.
But ARM still transfers some interest rate risks to borrowers.

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14
Q

Price Level Adjustable Mortgages (PLAM):
r = i + p + f
? mortgage ? is adjusted with level of ? each year.
- reduce expected ? risk (f) faced by lenders.

A

Price Level Adjustable Mortgages (PLAM):
r = i + p + f
Outstanding mortgage BALANCE is adjusted with level of inflation each year.
- reduce expected inflation risk (f) faced by lenders.

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15
Q

Optimal household choice between fixed & adjustable mortgages:
- ?: repaying the current loan and signing a new mortgage contract with another lender that offers ?? interest rate.

A

Optimal household choice between fixed & adjustable mortgages:
- Remortgaging: repaying the current loan and signing a new mortgage contract with another lender that offers more attractive interest rate.

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16
Q

Optimal household choice between fixed & adjustable mortgages (p1):
- Miles (2005) assumes that if family chooses variable rate mortgages, they would remortgage every 2 yrs, which is ? because many remortgage as soon as the ? period ends.
- variable rate & ? rate change over time.
- Variable rate mortgage generates ? : ?-term interest rates may rise more than expected.
=> make mortgages less ?.
- To what extent this uncertainty exacerbates the affordability issue depends on ? bet. interest rates and family income.

A

Optimal household choice between fixed & adjustable mortgages (part 1):
- Miles (2005) assumes that if family chooses variable rate mortgages, they would remortgage every 2 yrs, which is not implausible because many remortgage as soon as the teaser period ends.
- variable rate & teaser rate change over time.
- Variable rate mortgage generates risk: Short term interest rates may rise more than expected.
=> make mortgages less affordable.
- To what extent this uncertainty exacerbates the affordability issue depends on covariance bet. interest rates and family income (the extent to which they move together).

17
Q

Optimal household choice between fixed & adjustable mortgages (p2):
- Fixed rate mortgages generate risk for ?: ??, ?? & ?? may be lower than expected.
=> Real cost of mortgage ? income & house prices.
- In UK, remortgaging during fixed-rate period is associated with ?. Would families be willing to bear this cost or rather wait until teaser periods expire?

A

Optimal household choice between fixed & adjustable mortgages (p2):
- Fixed rate mortgages generate risk for borrowers: actual inflation, house values & nominal incomes may be lower than expected.
=> Real cost of mortgage > income & house prices.
- In UK, remortgaging during fixed-rate period is associated with penalties. Would families be willing to bear this cost or rather wait until teaser periods expire?

18
Q

Optimal household choice between fixed & adjustable mortgages (p3) ultimately depends on ? and ?? of:

  • house ?
  • ?? (short & long term)
  • household ?.
A

Optimal household choice between fixed & adjustable mortgages (p3) ultimately depends on variability and co-variability of:

  • house prices
  • interest rates (short & long term)
  • household income.
19
Q

Optimal household choice between fixed & adjustable mortgages (p4) - Other important factors:

  • Household ??
  • Cost to ?
  • ??? ratio.
A

Optimal household choice between fixed & adjustable mortgages (p4) - Other important factors:

  • Household risk preference
  • Cost to remortgage
  • Loan to Value ratio.
20
Q

Optimal mortgage (p1):
- When households borrow ? relative to their income, fixed rate mortgages are more ? because:
monthly mortgage repayments would make up a ? % of household income.
If interest rate rises, t’ family may need to cut essential expenses to make the increased mortgage payments.
=> risk of unexpected increase in interest rates are ?.

A

Optimal mortgage (p1):
- When households borrow more relative to their income, fixed rate mortgages are more attractive because:
> monthly mortgage repayments would make up a larger % of household income.
If interest rate rises, t’ family may need to cut essential expenses to make the increased mortgage payments.
=> risk of unexpected increase in interest rates are higher.

21
Q 
Optimal mortgage (p2):
- When households face risk of ?, fixed rate mortgages (FRM) are more ? because:
FRM provide insurance against ? in interest rates.
A 
Optimal mortgage (p2):
- When households face risk of unemployment, fixed rate mortgages (FRM) are more preferable because:
FRM provide insurance against increase in interest rates.
22
Q 
Optimal mortgage (p3):
- Conclusion: FRM could be attractive to certain households such as ??? & households with ??.
A 
Optimal mortgage (p3):
- Conclusion: FRM could be attractive to certain households such as first time buyers & households with uncertain income.
23
Q

Why are there so few FRM available in UK?
Miles (2005) explains:
- borrowers focus on ??instead of t’ overall cost. ? offer lower initial repayments regardless of APRC.
- borrowers believe BoE wouldn’t ? interest rates as many households are on ARM. If this is true, choosing ARM & ? every 2 yrs would be a ? choice for borrowers.
- Lenders prefer ARM bec they help shift ??? to borrowers.

A

Why are there so few FRM available in UK?
Miles (2005) explains:
- borrowers focus on initial repayment instead of t’ overall cost. ARM offer lower initial repayments regardless of APRC.
- borrowers believe BoE wouldn’t raise interest rates as many households are on ARM. If this is true, choosing ARM & remortgaging every 2 yrs would be a cheaper choice for borrowers.
- Lenders prefer ARM bec they help shift interest rate risk to borrowers.

24
Q

A major benefit of a PLAM is the mortgage payment increases closely follows borrower salary increases.
TRUE OR FALSE?

A

A major benefit of a PLAM is the mortgage payment increases closely follows borrower salary increases.
F

25
Q

Which of the following descriptions most accurately reflects the risk position of an ARM lender in comparison to that of a FRM lender?
? interest rate risk and ? default risk.

A

Which of the following descriptions most accurately reflects the risk position of an ARM lender in comparison to that of a FRM lender?
Lower interest rate risk and higher default risk.
Because:
The ARMs transfer interest rate risk from borrowers to lenders. As mortgage payments are more likely to increase in an ARM compared to a FRM, the borrowers are more likely to default on their payments in an ARM.

26
Q

Which of the following is a disadvantage of PLAMs?

The price level used to index PLAMs is measured on an ex post basis and historic prices may not be an accurate reflection of future price.

Lenders face high levels of interest rate risk under PLAMs.

A

Which of the following is a disadvantage of PLAMs?

X [The price level used to index PLAMs is measured on an ex post basis and historic prices may not be an accurate reflection of future price.]

Lenders face high levels of interest rate risk under PLAMs.
Explain:
Inflation is always measured on a historical basis and in a PLAM future mortgage payments are based on historical values rather than current changes in price levels or home value appreciation.

27
Q

ARMs were developed because lenders were tired of offering a limited selection of loan alternatives to borrowers.
TRUE or FALSE?

A

ARMs were developed because lenders were tired of offering a limited selection of loan alternatives to borrowers.
FALSE

28
Q

ARMs help lenders combat unanticipated interest rate changes.
TRUE / FALSE?

A

ARMs help lenders combat unanticipated interest rate changes.
TRUE

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